Divorce Can Hurt – A Case Study in the Tax Consequences

When I was a kid, my dad said something that has stuck with me throughout my life. Considering I grew up to be a CPA, the irony of his statement isn’t lost on me… He said, “Son, there are only two definite things we must do in this world, pay taxes and die.” The takeaway for me was that even in the most stressful and emotional times, such as a divorce, we must be vigilant about the tax implications of our financial decisions and agreements. Because when it comes down to it, my dad was right, the taxes will be due.

An often overlooked and misunderstood item of dividing marital assets between spouses in a divorce pertains to Qualified Domestic Relations Orders (QDRO’s). As illustrated below, if the recipient spouse has not properly considered their future after the divorce, QDRO’s can bring about an unplanned and significant tax liability to that recipient spouse.

A QDRO simply put, in a divorce matter, is a court order which transfers a portion of one spouse’s qualified retirement account(s) to the other spouse. This is typically a transfer from a qualified retirement plan or Individual Retirement Account (IRA) of the transferor spouse to an IRA of the transferee spouse.

So, what does it have to do with taxes? Let’s illustrate a scenario to help clarify potential tax implications:

After contributing to Spouse A’s employer sponsored regular 401 (K) plan over many years, the current market value of the account is worth $1,000,000. The court approves a QRDO requiring the transfer to Spouse B of half of the value of the 401 (K) account, which is $500,000. Assume that Spouse B has not considered their future financial needs after divorce and has not spoken with a CPA about those needs. However, Spouse B does know that the QDRO transfer would not be considered a taxable event if the $500,000 was transferred from Spouse A’s qualified account to Spouse B’s Individual Retirement Account and, subsequently, the entire $500,000 is transferred to Spouse B’s IRA account tax free.

Now let’s modify this scenario to say Spouse B, age 50, sometime after the QDRO transfer, decides to purchase a home, needs $80,000 for the down payment and Spouse B is in the 20% effective income tax bracket. Spouse B instructs the IRA custodian to disburse $100,000 from their IRA account with 20% tax withholding intended by Spouse B to cover 100% of the taxes due on the IRA withdraw. Well, the problem is, Spouse B’s net IRA withdrawal will only total $70,000.

Remaining Net after Income Tax and Early Withdrawal Penalty of $70,000

The key in the above example and why it became a 10% tax penalty event is that 100% of the QDRO funds were transferred per the QDRO order to an IRA owned by Spouse B when only $400,000 should have been transferred to Spouse B’s IRA. In other words, since the $100,000 IRA withdrawal was taken after QDRO transfer, the 10% early withdrawal penalty was applicable. Had the QDRO specifically instructed that the $100K be withdrawn from Spouse A’s retirement plan and given to Spouse B as a taxable retirement plan distribution prior to the transfer of the remaining $400,000 the 10% early withdraw, at a cost of $10,000, could have been avoided. The withdrawal would still be subject to the 20% income tax netting Spouse B $80,000.

As you can see from the above example, when it comes to divorce, there can be unexpected “land mines” which require the attention and expertise of an experienced financial consultant knowledgeable in tax law. Our litigation support experts, CPAs licensed in Iowa and Illinois and Accredited in Business Valuation (ABV), provide consulting services with a team-based approach. Whether we’re engaged prior to filing or after filing, we partner with attorneys to uncover, analyze, and explain in an understandable format the financial landscape of the case. Contact TDT’s Forensic and Valuation Team to assist you with financial challenges related to Business Valuation, expert testimony, forensic financial analysis or expert report rebuttals.